Examine the causes behind the rate cut proposed by the monetary policy committee headed by the RBI governor.

The Monetary Policy Committee (MPC) has again cut the repo rate by 0.25 percentage points. It was the fifth time since February 2019. The MPC retained the accommodative policy stance and signalled a strong resolve to support the revival of growth.

Why RBI reduced repo rate?

• The steep reduction in RBI’s FY20 GDP growth projection, from 6.9 per cent in August to 6.1 per cent.
• Economic activity indicators have remained weak, with a flat core infrastructure index growth, continuing weak automobile sales and a sharply lower services sector purchasing managers index (PMI) showing a deep contraction in September.
• Rural demand which is proxied by sales of two-wheelers and tractors has also contracted.
• RBI’s forward-looking surveys show an expected drop in capacity utilisation of manufacturing firms in Q2 FY20 and the Business Assessment Index also fell in Q2.
• Inflation has remained within the 2- 6 per cent target and the inflation forecast for October-March FY20 stood at 3.5- 3.7 per cent which is significantly lower than the 4 per cent mid-point and provides adequate buffers for even unexpected food, oil and other price shocks.

Why MPC has limited the repo rate cut to 0.25 percentage points?

Factor of Uncertainty

• There is a degree of uncertainty on both the effects of the fiscal stimulus measures already announced (particularly the bold and decisive corporate tax rate cuts) and those which are in various stages of implementation — as well as the additional measures which might be needed.
• These are expected to result in be compositional changes in expenditures and borrowings, the effects of which need to be better understood.
• Global financial market volatility, trade-related uncertainty, geopolitical disruptions to global supply chains will only add to domestic policy responses.

Inflation

• The household inflation expectations over a three-month and one-year ahead horizons have risen 0.40 and 0.20 percentage points. This is likely reflecting an adaptive response to the recent hardening of prices of some vegetables.
• For the RBI inflation expectations are a key input into monetary policy formulation, since hardening expectations usually translate into wage negotiations, which change inflation dynamics. Hence RBI has adopted a wait and watch approach.

Path of Lending Rates

• There is a switch of interest rates on new retail and MSME loans from the erstwhile MCLR system to one that is repo-rate linked.
• Hence RBI is keeping a watch on the path of lending rates over the next couple of months to study how the banks and industry responds.

The government, RBI and other agencies have already announced a coordinated set of counter-cyclical stimulus measures to revive consumption, investment and growth.

Topics: GS-III: Indian Economy Issues Relating to Planning